Las Vegas and Those Evil Short Sellers

It appears one of great villians of last week was the evil doer called the "short seller".  Never a crowd favorite, regulators banned shorting some 799 stocks of financial firms last week.  But what is a "short" and why are they so evil?  Or are they evil at all?

Back in my high flying Wall St. days, I used to enjoy frequent trips to Las Vegas, sometimes for business and sometimes for pleasure.  I didn't go to play blackjack or bet on sports, it was mostly for the restaurants, people watching and nightlife.  It is not as if I have any great objection to gambling, except that it targets people who are generally really bad at math.  Rather I just don't terribly enjoy playing a game where the odds are greatly against me regardless of my skill.  However, there are two games I enjoy- poker and craps.  Poker is a game of skill with an element of luck and also the only game I know where you don't play against the house. 

Craps is of course like all the other games insofar as the odds are against you.  Unlike other games however, there are dozens of bets and probably hundreds of strategies in craps, some of these bets even allow you to "hedge" your existing bets against a bad outcome.  As a statistics guy, I always found low-stakes craps to be an intellectual exercise as well as about the most fun in the casino.  After all, there are a dozen or so people throwing chips, yelling out bets like "$1 Yo!!!" and lots of high-fiving all around when the table gets hot. 

Craps is a community game where most people are rooting for the same outcome and fear the same pitfalls. The basic premise of the game is that a new shooter rolls the first "come-out" roll to establish "the point".  Provided the roll doesn't result in one of the many instant wins or losses (7, 11, 2, 3, 12), the point is established.  Let's say I come-out with 10.  Anyone betting the "pass" line is betting that I will roll a 10 before the dreaded 7 comes up first.  That my friends, is all there is to basic craps.  Since everyone generally wants to be on the same side, and understanding the math is more intuitive, most everyone at the table will bet "with" the shooter meaning they are rooting for that 10 instead of craps (7).  With me so far?

By now you are asking what does this have to do with short selling right?  I'm getting there, fear not.  The players betting with the shooter are called "right bettors".  Yet there is a whole other side of the game rarely discussed called "wrong betting".  Wrongs bet against the shooter and are generally disliked as if they are terrorists or are from the dark side.  Kind of like that one guy in the local bar rooting for your home team's rival.  You know the one because he is the only one hooting when the rival team scores. 

A fund manager friend of mine is a wrong bettor and we would occassionally find ourselves in Vegas together on business.  Time being a necessary luxury for poker which we didn't have, we might spend an hour or two at the craps table, where he would be the only one betting against everyone else.  The key here is that the expected outcomes are exactly the same for a wrong bettor as they are for a right bettor because the payoffs change to reflect the different odds.  When I asked him about this, he said "I know the odds are the same; I just figure most people in the casino are losers, so I am betting on them losing".  Fair enough, I guess, if not mathematically accurate.  The math may be the same, but the perspective is different for sure.  The really fun part of sharing the craps table with him was when the table would get hot and everyone would start taunting him.  Even more fun was when the table would go cold and they the verbal jabs and invitations to take a hike would fly- kind of like what happens to short sellers.

Remember the old mantra "buy low, sell high"?  Obviously it is a fundamental rule of trading, but it doesn't say anything about which to do first.  Most people assume you should buy low, wait for it to go up and then sell.  A "short" seller is one who does this in the opposite order.  Say you think GM is a terrible company and going to fall in value, so you sell 100 shares the stock at $35 (proceeds of $3500) and wait until it falls to say $20, when you buy it back, costing $2000 in proceeds.  This short sale earned you $1500 on the difference between two prices.  Instead of betting with the company, you bet against it, much like our wrong bettor friend.

The part of the short seller story I did not mention yet is how you sell shares you don't own so you can buy them back later.  Obviously this little detail is key to being able to execute the short sale.  The shares of most companies are loaned to shorts for a fee.  Got that?  Essentially, a short borrows that 100 shares of GM from someone who is holding it as an investment.  As with all borrowing, they must return those shares regardless of the price at some point in the future, which necessitates buying at some time in the future.  If a trader sells shares they do not have in their possession, it is called "naked shorting" and is strictly illegal.  It has always has been illegal, yet like most rules, some small minority always find a way to break the rule.  When caught they are prosecuted.  Naked shorting is not the subject of all the recent shorting rules except that in the past few weeks regulators made sure everyone knew they were serious about not shorting naked.

Plain old shorting is a legitimate tool for investors.  While we often picture some wealthy, powerful and highly secretive hedge fund shorting a stock, then feeding the rumor mill negative stories to help the stock crater, and profiting massively, this is largely a myth (it does happen, but it is not general practice or widespread).  Most often shorting is part of a much more sophisticated strategy.  Say for example you really think Toyota is the best auto company and is going to do very well.  Yet you are also afraid of the slow auto market.  You might buy Toyota shares and short GM shares, helping to insulate this "paired" trade from the general tide of the market.  If both go up or both go down, you don't gain or lose; you only gain if Toyota outpaces GM.  Shorting in this case helps you isolate the difference in performance between two firms.

There are other ways to use shorting, none of which are clearly amoral or evil, but much like our wrong bettor will be reviled anyway.  This evil image often comes from the fact that owners of shares actually own a piece of the company.  They are investors who have a vested stake in the improvement of their company. Shorts on the other hand, have no such vested interest and they hope to profit from a correction in the firm's value.  You may determine that shorting has no positive contribution to our capital markets.  However, as I described in previous paragraphs, there are positive, constructive uses of shorting.  Furthermore, I await a good argument why unchecked speculation for buyers is moral, while betting that overpriced speculators are wrong (shorting) is not. 

Aside from moral arguments, were the regulators wrong to ban short selling during this crisis?  This answer may suprise you- I don't think it was necessarily wrong to do so.  A panic is the absolute lack of confidence in the system.  Allowing shorts to continue fuels the vicious cycle where selling begets more selling, which is dangerous to the foundation of the entire system.  Even 10 wrong bettors at the table are not going to take down the whole casino, but shorts may assist in compounding the ill effects of a panic. 

So while it wasn't necessarily wrong or out of line to ban short selling, it was certainly misplaced and probably ineffectual.  Short term speculation is eventually subject to fundamentals, so if financial stocks are destined to prices of $0, they will ultimately get there with or without the help of shorts.  Remember too that every short sale must end in a buy.  That's right- a long investor can buy GM and never sell; but a short seller must buy back those shares to return to the lender.  That forced buy also creates buying pressure which no one seems to find offensive.  Consider that the regulators and Congress are the ones guilty of allowing financial institutions to lever up 30 or 40:1.  Naturally, they need to blame someone and take some of the heat off them.  Who better to receive that action than the nebulous group known as short sellers who just seem wrong to the masses?  In short  :-) , short selling is not the evil it is often made out to be, but there are a (very) few times when banning it is ok and this is one of them.  Just don't let them fool you that the shorts are responsible while the fox guards the henhouse and the problems are far more severe than a few speculators.  Ironically, it was speculation (mortgage securities, housing) that caused this problem, only that speculation was not regulated like short selling is and turned out to be really dangerous.  Congrats if you made it this far.  Too long for my taste, so I'm done for now.